How to Buy Silver at a 93% Discount

Why Pan American Silver is among the premier bargains on the stock market.

I know where you can buy silver at a 93% discount compared to the current spot price.

Yes, there is a slight catch, but for Fools who take a few moments to contemplate the precise nature of that catch, I think the resulting discount will nonetheless stand out as one of the greatest bargains available to investors today.

With 2011 output of 21.9 million ounces of silver, Pan American Silver(Nasdaq: PAAS) counts among the world's elite primary producers of the increasingly precious metal. Thanks in part to a massive 76% increase in the average realized price of silver last year, the miner unearthed $855.3 million in revenue, and poured on an adjusted net profit of $252.3 million. That comes to a cozy net profit margin of nearly 30%! As a quick teaser to the full valuation discussion to follow, consider that the stock is therefore trading at a trailing price-to-earnings ratio of 7.9! For those who understand how to value resource stocks in particular, that astonishingly low ratio will stand out all the more.

Cheap silver is nice, but cheap silver growth is a golden ticketValue investors will marvel at the bargain here, and growth seekers will likewise find bounty in Pan American's powerful outlook for a rapid doubling of silver output by 2015. That growth profile has three main moving parts for Fools to consider:

The company is in the process of acquiring gold and silver sensation Minefinders(AMEX: MFN) in a landmark $1.5 billion strategic transaction. The deal comes just as Minefinders was itself preparing to double silver output from its flagship Dolores mine in Mexico to 7 million ounces per year with the addition of a mill. With meaningful gold by-product credits, the Dolores mine will also serve to moderate Pan American's slightly elevated operating-cost structure.

Pan American's Navidad project in Argentina will count among the world's premier silver mines once it enters production, with estimated average annual output of 19.8 million low-cost ounces, less 12.5% of production from a portion of the mine that will be payable to Silver Wheaton(NYSE: SLW) as a silver stream. The fact that Pan American must overcome a provincial ban on open pit mining before proceeding to construction is arguably at the heart of the stock's deep-bargain valuation. But Pan American conveys considerable confidence that an exception will be granted for this economically significant project during 2012.

Pan American can earn a 55% interest in Orko Silver's La Preciosa project by bringing the project fully into production, and the company has made it abundantly clear that it intends to do just that. Once completed, that mine will add a further 3.75 million attributable ounces to Pan American's ballooning production profile.

So just how cheap is Pan American Silver?Oh, it's cheap, all right -- Pan American holds 235.3 million ounces of silver in proven and probable silver reserves, plus 708.8 million ounces of measured and indicated resources that primarily reflect the company's world-class buried treasure at the Navidad project. Combined, that amounts to 944.1 million silver ounces. Mind you, for purposes of this discussion we will ignore the company's 1.8 million ounces of gold in those same categories (before the gold-heavy Minefinders acquisition), because gold production is best reflected through its positive impact on the company's cash-cost structure for silver output. Also excluded from this discussion are 271.7 million ounces of inferred silver resources.

With Pan American's enterprise value at $2.29 billion, the market has assigned a value of only $2.43 to each of the 944.1 million ounces of silver, most of which the company stands a reasonable chance of extracting over the long haul. With silver trading above $35, investment exposure to these underground ounces is available at a 93% discount to the current price of silver. Now, because accessing that silver is a bit more complicated than simply opening up a vault, a certain portion of that discount makes perfect sense to account for the costs of extraction, the myriad risks and challenges inherent in mining activity, etc. That's the catch I referred to earlier.

But after accounting for the prevailing cost of silver production, rising though it may be, I perceive a massive moat of value between long-term cash margins for silver and Pan American's asking price (so to speak) of $2.43 per ounce. Pan American enjoyed a cash margin greater than $25 for every ounce sold last year! Although production costs for Pan American have been on the rise, the company's pending acquisition of Minefinders will strongly alleviate those cost pressures with a golden salve.

Comparisons to other familiar mining companies may be of some help to us here. Consider legendary silver miner Hecla Mining(NYSE: HL), whose stock has endured a painful hangover following the temporary closure of one of its mines. I have drawn attention to the meaningful bargain present in those shares, and that's with a comparable valuation of $4 for each ounce of proven and probable reserves plus measured and indicated ounces in that miner's gorgeous asset portfolio. Some of that relative premium over Pan American is warranted by Hecla's lower cost structure, but not all of it. Just last week, I declared Kinross Gold(NYSE: KGC)a golden bargain by pointing out that investors essentially have access to the company's massive treasure in gold at a 92.5% discount to the gold price.

I am not alone in perceiving major value here. Minefinders CEO Mark Bailey told me just last month, "I like the stock. I like their paper. I think with our assets, and their current and future assets like Navidad, I'll see a real re-rating of the company, and a lot of upside back to that $40-plus share price we saw in 2011."

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